Focusing on provisions that affect estate-planning strategies

In September 2021, the U.S. House says and Means Committee released draft legislation intended to raise revenue to fund the proposed trillion-dollar budget-reconciliation bill (originally proposed at $3.5 trillion, but now set to be scaled down). Included in the draft legislation are numerous proposals that would affect both personal and business-tax planning. However, the focus of the following summary is on the tax provisions that most directly impact estate-tax planning — specifically the substantial changes to the rules governing grantor trusts. If enacted, the tax-planning strategies and the tax benefits now available to grantor trusts would essentially be eliminated. Notably, however, any grantor trust created and funded before the proposed legislation is enacted, to the extent it becomes law, would generally still receive the benefits and tax treatment provided under the current law, not considering any contribution made to the trust after the law is effective. 

Ultimately, although it is unknown whether the proposed provisions will become law, individuals need to evaluate their current estate-planning strategies and must consider doing so quickly, given that certain proposals will take effect as of the date the legislation is enacted, while other tax proposals will become effective on Jan. 1, 2022.

Proposed changes to grantor trusts

Under current law, a grantor trust is one in which the trust assets are treated as being owned by the grantor (generally, the creator of the trust) for income-tax purposes, meaning the grantor pays tax on the trust income as if such income was received directly by the grantor. For estate-tax purposes however, the trust assets fall outside of the grantor’s estate and therefore are not subject to federal estate tax upon the grantor’s death. Essentially, grantors benefit by diminishing their estate by the amount of tax paid on the trust’s income while also benefiting from having the appreciating assets held by the trust excluded from their estate.

To curtail this tax-planning strategy, the proposed federal legislation would add two new tax sections to the Internal Revenue Code (Section 2901 and Section 1062), both substantially limiting the effectiveness and use of grantor trusts (other than revocable trusts). Generally, the proposed provisions would alter tax treatment of grantor trusts by automatically including the trust assets in the grantor’s estate for estate-tax purposes. Specifically, if the grantor is the deemed owner of any portion of the trust, then:

• The assets of that grantor trust will be part of the grantor’s gross estate

• Any distribution from a grantor trust (to someone other than the grantor, the grantor’s spouse, or to discharge a debt of the grantor) will be treated as a taxable gift from the grantor to the person receiving the distribution

• All trust assets will be treated as a taxable gift when the trust ceases to be a grantor trust during the grantor’s life (i.e., upon “turning-off” grantor-trust status)

• Any sale between the grantor and the grantor trust would be treated as if it were a taxable sale to a third party

Again, these provisions would only apply to grantor trusts created or funded on or after the date of enactment and to any portion of the trust that was created prior to the enactment date, which is attributable to a contribution made on or after the enactment date. These proposed provisions impact any grantor trust that is defective for estate-tax purposes, meaning not only would they affect intentionally defective grantor trusts (IDGT), but also any trust that is considered an IDGT for tax purposes, such as irrevocable life-insurance trusts (ILIT), grantor-retained annuity trusts (GRAT), spousal lifetime-access trusts (SLAT), and qualified personal-residence trusts (QPRT). For instance, under the proposed legislation, a grantor would no longer be permitted to make annual contributions to an ILIT (such contribution generally being used to pay the premiums on an insurance policy) without such contributions causing all or a portion of the existing ILIT to be included in the taxpayer’s estate.

What to do now?

Individuals need to significantly reexamine their estate-planning strategies to ensure they comply with the proposed legislation and determine what actions need to be taken before the effective date of any change. Notably, individuals can still create and fully fund a grantor trust before the enactment date and avoid the trust’s assets being included in the grantor’s estate, to the extent the assets are not later included by way of any of the provisions discussed above. Additionally, individuals should also consider engaging in any sales or exchanges with an existing grantor trust, using any remaining estate and gift-tax exemption available before the exemption amount is reduced (which would be as much as $5.85 million), and reevaluating the overall effectiveness of their current tax-planning strategy. 

To be clear, although these provisions are only proposed legislation, individuals are encouraged to consult with estate planning and tax advisors to determine the effect this proposed legislation would have on them and whether any action should be taken to ensure their estate-planning strategy will continue to meet their needs.

Ryan M. Hartnett is an associate attorney at Mackenzie Hughes LLP in Syracuse. He practices in all areas of federal, state, and local tax law, focusing on corporate tax planning, employee benefits, estate and gift tax, and tax controversy. Contact Hartnett at rhartnett@mackenziehughes.com.